Rate setting not for tackling inflation, room for rate cut opens once RBI confident of below 4% inflation for 12 months: Axis Bank's Neelkanth Mishra

Neelkanth Mishra, Chief Economist, Axis Bank

Axis Bank’s Chief Economist Neelkanth Mishra said that rate setting by the monetary policy committee (MPC) of the Reserve Bank of India (RBI) is not for tackling inflation concurrently, and the room for rate cuts opens if the central bank is confident that inflation will remain below 4 percent in next 12 months.

“Rate setting is not for tackling inflation concurrently. Interest rates influence with a lag, and therefore, it is very important to have a forward looking outlook, that what is inflation expectation in the next 12 months. If you can confidently forecast that in the next 12 months inflation is likely to below 4 percent, then there is room to cut rates,” Mishra said during an interview with Moneycontrol.

He further added that the central bank does not have room to cut rates in the next 13-14 months, and if rate cuts happens in February policy, then it will lead to increase in fixed income market yields.

Mishra said that if the rate cut happens at this level of inflation, then it will give a signal to market that the central bank is fine with the high inflation.

The talks of the rate cut emerged after India’s GDP growth numbers remained sluggish in the second quarter of the current financial year. However, the RBI kept the rate and stance unchanged in the December monetary policy, but provided some support with the cut in the cash reserve ratio (CRR).

Edited excerpts:

What will be implications of rate cut if it happens in February?

If the rate cut happens despite inflation staying high, then it will force financial markets to increase their expectation of medium term inflation, which means that most of the fixed income market yields may go up.

If its starts to cut rates without headline inflation coming down, the markets will start expecting that RBI is ok with 5 percent inflation.

Inflation is expected to come near the target of 4 percent in next fiscal year, will that be enough for RBI to cut rates?

It is not. Rate setting is not for tackling inflation concurrently. Interest rates influence with a lag, and therefore, it is very important to have a forward looking outlook, that what is inflation expectation in the next 12 months. Unless you see and you can convince yourself and the market that inflation in the next 12 months is going to persistently be below 4 percent.

If you can confidently forecast that in the next 12 months inflation is likely to below 4 percent, then there is room to cut rates.

In India, we do not see inflation easing quickly: over the long term, core and food price indices move together. Though food relative to core, and vegetables relative to food, are both at cyclical highs, the supply response may lag the demand boost from income-transfer schemes.

The bonds yields you said might go down further, and this will lead to narrowing gap between India and US bond yields. Will this sustain the flows of FPIs in debt?

The benefit of the index (JP Morgan bond index) is if the assets of $240 billion are benchmarked to that index and India's bonds have a 10 percent weight. So, we have to keep $24 billion outstanding. It can go to $20 billion, but it will not go to zero.

Considering the demand, the fiscal consolidation, can we see further reduction in borrowing numbers?

It should be flattish. The government will not change much of its borrowing and it will have positive impact on the bond yield.

Will new governor adopt new strategy to defend rupee?

Look at the people who are coming in, they are bureaucrats. They are extremely smart people. These bureaucrats are consensus builders - no one person can be a champion on foreign currency, bank supervision, currency volatility, overnight liquidity, Basel-II norms, growth forecast, inflation. If one person is not expert, then you have to do teamwork. If the team is the same and the one who is giving feedback is also the same.

At best, you can marginally change the direction of travel for a medium term.

Better demand-supply for government bonds though should help reduce yields. We expect USDINR volatility to rise, though it would be unwise to expect USD strength to last the year.

Previous governor has set a high benchmark for the new governor, how do you think the new governor will maintain that benchmarks?
He is very capable and one only hopes that the kind of volatility that some of the earlier central bank governors have seen like the financial crisis and all doesnt arise. I am hoping that nothing like previous crisis will emerge, which is good for all of us and for the market as well.